The Big Switch: from energy-only to capacity

In the world of electricity market nerds the Ford vs Holden debate of the past decade has been about how you pay for the electricity generated. This has come down to two different models: energy-only market design and capacity markets.

Energy-only markets are for the purists: they pay generators only for the electricity they dispatch into the system. It’s an efficient, tough-love market. Capacity markets are more like a modern-day primary school sports day: everyone wins a prize. Generators get paid not just for how much electricity they generate, but for turning up. This is to make sure that, in the event they are needed, they are still there to help out. Energy-only markets set the price, while in capacity markets, someone has to pre-set the value of the capacity. That’s a permanent and institutional market intervention. It almost invariably means paying too little, or more likely, too much.

Possibly the biggest energy market policy news not just this year, but this century, is that the paragon of energy-only market purity, Australia’s National Electricity Market, could be switching to a capacity basis, albeit a more low-key version than its WA equivalent. The advice from the Energy Security Board is a proposed package of reforms that would switch the NEM’s allegiance by introducing capacity payments for generators.

The details in a moment. The big winners here if the reforms go ahead will be the A-team of governance agencies (AEMO, AEMC, AER) who are now united under the auspices of the Energy Security Board (ESB) and are brokering these reforms. This may signify the slowing of the gradual decline of national electricity market policy into a state-based, go-it-alone, approach.

The other big winners might be owners of generators that can provide capacity, but in particular anyone who is dispatchable, like coal, gas, hydro, batteries and pumped hydro. But this is less certain, because they might have to give up the possibility of very high prices and ensuing revenues as part of the deal.

The losers are renewable developers who wanted more of the same conditions that have been driving world record pace for wind and solar development: state-based intervention, government support and continued funding of renewables projects. They still may get these anyway, of course.

The other potential losers are consumers. While everyone wants their lights to stay on, consumer advocates will be wary at yet another new cost to be added to their bills. Again, this depends on how such capacity payments are applied. If the reform works well it may have little impact on final bills with the capacity payments being offset by lower wholesale prices because there is more supply in the market.

On early numbers the reforms proposed by the ESB seem likely to succeed. State governments like backing renewables, but they really hate blackouts. If the big states like NSW and Victoria get behind this, then it’s a done deal.

To understand this reform it’s important to understand what has changed. Energy-only markets worked well in a mostly baseload generation system. That means big coal or nuclear power stations, running all the time, turning up in the morning and evening peaks and down at night.

This market uses highly variable wholesale prices to signal to the stack of other generators to jump in and out. When spot electricity prices rise to the hundreds and thousands of $/MWH, that’s not consumers being ripped off, that’s just the price it takes for very occasional peaking generators to fire up. Consumers don’t directly pay those eye-wateringly high prices, they pay for the insurance policy – a cap or swap contract – that protects them against those prices. This is where you find the NEM’s existing capacity payments – hidden in the contract market. The big difference is the market works out how much capacity to pay for and how to pay for it, not a government or the market operator.

This design doesn’t work so well when the grid has high levels of renewable generation. Why? Because big renewables are like a wild child. Wind will run crazy all afternoon and half the night and then suddenly stop at 4am. Solar will run when there is direct sunlight. These generators are highly indifferent to the price signals being sent by the market. They only want to switch off when prices get so negative they lose more than they make from generating renewable certificates.

This is sending dispatchable generators to the wall because the more renewables are suppressing the price, the less often they can jump in and make enough money to remain commercially viable. If they shut down, then the same problem bedevils any new generators. They have to sit around waiting for when it’s dark and still. And then suddenly they are needed really, really badly.

The purist market-based solution is simple enough: increase the maximum wholesale price paid to generators (called the Value of Lost Load or VoLL) so that the risk of paying these super-high prices is higher and the value of the caps (insurance) market is robust enough to keep firm generators alive. But, like the idea of introducing a carbon price, this requires a level of political maturity beyond modern-day Australian parliaments.

A capacity payment as proposed by the ESB accepts this reality and pays enough to these generators still needed to keep the lights on to stay in business. This may slow renewables build, and extend the life of these generators, which is bad for emissions. The alternative is crisis funding for emergency generators. Which is expensive.

What needs to go with this design is a way of ensuring emissions are factored into the capacity payments. Higher emissions capacity should exit first. Cleaner capacity should be better rewarded to reflect its lack of emissions. This was how the National Electricity Guarantee (NEG) was supposed to work.

Such an approach would possibly benefit technologies that can store and dispatch renewables, like batteries. Most batteries in the market need to sell or provide specific technical services to cover their costs. There just isn’t enough spread in even a more volatile spot electricity market for a regular arbitrage play to cover the capital cost of the battery. That’s why there is more than 10GW of large-scale battery projects queued up waiting for a government cheque to reach financial close. Capacity payments may be a better option.

If this big reform does go ahead it will be a huge reform in the 20-year history of the NEM. One that needs to be fully costed and may require extensive market re-design to reflect the changes. It took 5-minute settlements five years to get from concept to execution, and this is much more complex. There are huge transitional risks and challenges arising from such a change including investment paralysis. It’s the electricity market equivalent of Bob Dylan going electric: it changes everything.